Lows set for retesting on European concerns

I get the feeling there are a few brave souls contemplating the long side in global equities. I feel that would be a mistake.

It’s been three months now since I suggested it was time to move to the sidelines. I felt there was every chance the late February highs “could prove the best we’ll see in 2012".

I’d jumped the gun a tad, as prices managed to push a further 3 per cent higher before running out of steam. This reflected buying support in the wake of the European Bank’s second tranche of three-year refinancing and hopes that the US Federal reserve might be ready to press the button on a third round of large scale asset purchases. Three months on and we’re now tracking 6.5 per cent lower, with the S&P/ASX200 again threatening to break below the psychologically significant 4000 level.

I’m still expecting a retest of last year’s three-year low of 3765, though the news flow of the past few weeks suggests this may not be the limit of the current sell-off.

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Back in March, I explained my risk-off stance was predicated on the fragile nature of the US recovery, the rapid deterioration in Europe and early signs of a slowing in emerging markets.

All three drivers still apply, though I can’t help feeling the downside risks attached to all three have markedly increased.

Clearly Europe is the biggest concern. Watching Spain implode, investors are at last coming to appreciate a disorderly disintegration of the euro zone is a very real possibility.

I still feel this is the least likely outcome, but it can no longer be viewed as a one in a hundred tail risk.

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What now looks more likely is the exit of one or a number of the expanded euro zone periphery – we’re talking the economically insignificant Greece, Ireland and Portugal along with euro zone heavyweights Spain and Italy.

Losing all or any of the former would create significant, but manageable, market disruption. Should either of Spain or Italy be forced to go, we’re probably talking a major market meltdown.

This is first and foremost a banking crisis. Individually, banks are over-geared and underfunded. They’re holding collateral in the form of government debt that’s falling in value by the day. They’re sitting on loan books that are going backwards, thanks to a recession that’s going to get a whole lot worse before it stands a chance of getting better.

In just four weeks they’re going to have to prove they’ve met the European Banking Authority’s 9 per cent core tier one capital ratio. That’s not going to happen.

On Wednesday the European Commission finally conceded Europe needs a “banking union" that included “integrated financial supervision and a single deposit guarantee scheme".

Such a trans-European approach is long-overdue. Last week we discussed how European banking remains a series of national systems that function under national rulebooks. This meant “there’s no such thing as a single market when it comes to banks".

We’re unlikely to see this change any time soon, given the European Commission warning “the pace and sequencing of these developments" will first need to be worked out “including a roadmap and a timetable".

That sounds like too little too late for me, given how close we’ve moved over the past week to the prospect of a major systemic banking collapse.

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In March we talked of “early signs of slowing" in emerging markets. Today that slowing is a reality. This week we’ve seen rate cuts in Brazil and India.

China is still talking fresh fiscal and monetary stimulus but is yet to make any firm commitment. The big worry for all three is how this will affect underlying inflation.

China in particular, is aware its best chance of lifting growth is through domestic stimulus, but it also knows doing this while it’s keeping a lid on its currency can’t help but exert upside pricing pressure. HSBC’s Qu Hongbin believes this won’t deter authorities.

He’s expecting a strong mix of both monetary and fiscal easing, capable of lifting gross domestic product growth back to 8.5 per cent in the second half.

But he cautions against expecting a repeat of the 2009 stimulus, as authorities are understandably keen to avoid “the unpleasant side effects" that followed that near $US400 billion spend.

I get the feeling they’re going to try to get away with the bare minimum. If they do, that could prove a costly mistake.

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Which just leaves the US; in March we worried about a “fragile recovery". That’s certainly been borne out by the numbers. The worry now is how the European recession is going to affect second half US growth.

US fund manager John Hussman is expecting the worst. He notes the high correlation between US and European GDP over the past decade. If both the euro zone and the UK are in recession, it seems unlikely US growth will be able to avoid being dragged lower. Trade has been the biggest contributor to growth over the past two years. That’s where most of the European pain will be felt. I’m still hearing talk that we’re going to see the Fed save the day, with one more round of quantitative easing. But with US treasury yields now pushing multi-decade lows, you have to wonder what the Fed thinks it can achieve by again stepping in as a buyer.

US Treasuries are already in high demand as the default safe haven play. Against such a backdrop, it’s hard to see how the Fed could achieve either of its twin goals in undertaking large scale asset purchases – further lowering long-term interest rates and encouraging buying of higher risk assets.

None of this bodes well for the outlook for equities. In March I suggested if you’re ready to move risk-off, it may be wise to push to the front of the queue.